Overview : Southern Europe, Fragile Recovery

Second quarter GDP figures and the latest survey data point towards a stabilisation of economic activity in Southern Europe (Italy, Spain, Portugal and Greece), raising hopes for a return to growth in the near future. Behind this potential recovery there is a new balance between internal demand, which is less hamstrung by the relaxation of austerity, and exports, which have been reinvigorated by three years of internal devaluation and a diversification of markets. However, this is still a fragile balance.

Despite the recent deadlines set by the European Commission (EC) to reach a budget deficit of 3% of GDP1, Southern European countries will need to make significant fiscal efforts in 2014. Although the pace of consolidation has slowed, the targets remain ambitious. Southern European countries will not be able to count on a return to growth to save them from discretionary measures. With the distinction between the nominal deficit and the structural deficit (which strips out cyclical effects) the EC’s assessment of government policies now looks at the fiscal effort and its execution, rather than at the results alone. As well as the 3% of GDP deficit target set out in the Maastricht criteria, there is now also a 0.5% structural deficit target included in the Treaty for Stability, Coordination and Governance (TSCG). In addition, countries with excessive debt must reduce by 1/20 per year the gap between their debt ratio and the 60% of GDP limit. In short, the adjustments in Southern Europe are far from over.

And yet, their political situation is delicate. In Portugal, the cracks in the ruling coalition that appeared in early July were papered over by a ministerial reshuffle, but profound differences on fiscal policy persist between the PSD and CDS-PP parties. The preparation of the budget, due to be presented to parliament on 15 October, could be a source of renewed tensions. In the meantime, the government will attempt to use the Troika’s 8th review, which begins in mid-September, to seek a further relaxation of the austerity cure. The government has already argued its case, in the run up to local elections on 29 September. However, given that there have already been two revisions to fiscal targets within the last year, that public debt already stands at 130% of GDP, and with at least one eye on Germany’s general elections on 22 September, the Troika will probably stand firm.

The Troika’s inspectors will also visit Greece during September. Here, the coalition, which now has only a 5-seat majority in parliament, is looking increasingly wobbly. Fresh demands from lenders for fiscal consolidation and/or structural reforms could push the New Democracy-PASOK alliance over the edge and trigger early elections.

Lastly, in Italy and Spain legal matters could threaten political stability. On 9 September a Senate Commission will begin to consider the possible expulsion of Silvio Berlusconi, prior to a potential Senate vote on the move. The removal of Mr Berlusconi would cause his People of Freedom Party to withdraw from the government, thus bringing it down. In Spain, corruption scandals affecting the country’s Prime Minister, Mariano Rajoy, look like a less direct threat for a government that enjoys an absolute parliamentary majority, but could dent its legitimacy. With a quarter of the workforce unemployed, and after three years of fiscal rigour, there is a very limited appetite for further austerity measures. So Southern European governments will have to continue their consolidation efforts but their room for manoeuvre is limited. This could result in a resurgence of tensions between North and South while Greek and Portuguese programmes coming close to maturity (mid-2014), solutions to their financing issues will need to be found quickly. Thus political risk could return to the centre of the European stage, bringing market uncertainty in its wake.

Over and above these purely European risks, the South’s recovery could also be held back by slowing growth in emerging economies, particularly the BRIC nations of Brazil, Russia, India and China2. If the export performances of Spain and Portugal have been remarkable over the past three years, this is in part due to the fact that these countries have diversified their export markets beyond the euro zone and into emerging markets. The share of Spanish exports going to the euro zone fell from 55% in Q4 2010 to 49% in Q2 2013. Over the same period the corresponding figure for Portugal fell from 64% to 59%.

The slowing of emerging economies, if it continues, will result in slower demand for Southern European countries. Of course, an improvement in the economic situation in the euro zone could pick up the slack. But on the aggregate level too, emergence from recession will depend on international trade. The data for the second estimate of GDP for the euro zone, published this week, have confirmed a return to growth in the second quarter. GDP grew by 0.3% q/q. The details of the components show that demand is still hesitant: consumer spending and investment grew by 0.2% q/q and 0.3% q/q respectively whilst exports were up 1.6% q/q. In the second quarter, intra-zone trade by value accounted for less than half the trade in goods and services, and a slightly smaller share than in the first quarter. Finally, although the Economic and Monetary Union remains highly integrated as far as trade is concerned, it is not yet in a position to provide its members with adequate markets to offset the weight of austerity and the slowing down of the major emerging economies. These two factors could still hamper the recovery in Southern Europe.

BY Thibault MERCIER